A growing segment of lower and middle class people are under stress to meet monthly obligations such as rent, groceries, gas, and rising interest rates on adjustable mortgages. Meeting such monthly obligations is difficult enough and often leaves these people with little room, if any, for adapting to emergencies or other unexpected costs. In addition, many of these people are often perceived as credit risks.
Traditionally, banks and credit unions are the source of small loans to consumers. However, since deregulation of the banking industry in 1980, profit pressure has forced many banks to closely scrutinize unprofitable products. Many branches have closed in lower income neighborhoods where on-deposit amounts couldn't justify branch cost. A number of banks merged during the past two decades to achieve cost efficiency in scale. And loan products that were not stand-alone profitable were discontinued. As banks are governed by their state of incorporation usury law, an annual percentage rate (APR) cap must be adhered to when pricing interest. In addition, safety and soundness rules governing the acceptance of loan applications means that banks may spend in a range of about $100 to $200 internally to originate one consumer loan. The internal costs include credit checks, income verification, collateral securitization, paperwork processing, etc. In order to be profitable, banks must recuperate these internal costs while still adhering to APR pricing regulations. The only feasible way to recoup such internal costs is for the banks to loan substantially large sums of money over many months. As a result, commercial banks will typically lend a minimum of $2,500 over a minimum of 24-36 months. This size of loan, combined with the number of periods outstanding and APR rates, allow banks to recover their internal costs and turn a profit. As such, banks have naturally avoided short term, small dollar loans. Given their APR usury caps and internal costs—there is practically no way for commercial banks to profitably lend small credit over a period of only a few weeks.
For Americans who are cash strapped, at their credit card limit, and who simply need “bridge” funds to tide them over till the next paycheck—small loans are an essential financial product. They cannot find this class of credit at their traditional bank. An industry, commonly referred to as the “payday lending” or “payday loan” industry, has stepped in to fill a need for these people by providing early access to needed money through short term, high interest payday loans. The technical banking term for this type of transaction is called a “short-term deferred deposit loan.” Over the past decade, the payday lending industry has grown to generate a loan volume of about $40-Billion per annum where the fees received from this loan volume are about $6-Billion per annum. One reason for the growth, success, and staying power of the payday lending institutions is that mainstream banks and credit unions cannot affordably originate, transact, and manage small, short-term cash loans. In short, the transaction costs for the banks and credit unions are invariably too high in view of the requested loan amounts and further in view of the real or perceived credit risk. One way the payday lending industry deals with this conundrum and minimizes its risk is to couple the loan to the individual's paycheck and make the duration of the loan no more than one paycheck cycle (i.e., the individual must pay off the loan with the next paycheck received).
Due to the practices of the payday lending industry, many individuals find themselves trapped in a downward, financial spiral. It has been estimated that over 6,000,000 people access “payday loans” as a source of cash, some for legitimate emergencies and others to simply meet the financial demands of everyday life. At present, the only avenue for these people to obtain short term loans is to subject themselves to the practices and fees of the payday lending industry.
The payday lending industry started as small, individually owned neighborhood shops that offered two week loans (ranging from $300-$500) in exchange for a fee. Borrowers would sign an agreement and provide a post-dated personal check for the amount borrowed and return at their next payday to repay, in cash, the loan amount or alternatively authorize the lender to cash the post-dated personal check. In exchange and after a verification of the borrower's employment and residency information, the shop owner (i.e., lender) would front the cash less a loan fee. Typically, the fee is between about $15-$25 per $100 borrowed. By way of example, a $300 loan request minus the fee would yield net cash to the borrower of about $225-$255. According to the Colorado chapter of PIRG (Public Interest Research Group), the typical payday lender charged consumers an Annual Percentage Rate (APR) of 470% and an average fee of $18.28 to borrow $100 for two weeks. See http://www.tomorrowsmoney.org/youngpeople/section.cfm/400/2531.
One operating tenet of the payday lending industry is that the full amount of the payday loan must be repaid on the borrower's next payday. Often, the lender provides a reminder to the borrower shortly before the loan becomes due and payable. Inevitably, some borrowers find that they are unable to repay the loan in full on or before the next payday. The lenders have dealt with this dilemma by allowing the borrower to “rollover” their outstanding loan. Many times, this rollover is done by the same lender. The lender simply executes a new agreement for the amount of the outstanding loan with a new fee and gives the borrower till the next payday to repay.
Multiple consumer organization studies indicate that this rollover behavior happens, on average, about nine times per loan. Referring to FIG. 1 and using the example provided above with an initial loan request of $300 having a loan fee of $25 fee per $100 borrowed and assuming that the borrower rolls the entire loan amount over each time, the cumulative fees for rolling the loan over nine times would be $675 to the borrower. This example shows that the fees for rolling the loan over can and often do exceed the original loan amount. In this example, the fees exceed the initial loan request of $300 by 225%. The practice of rolling over payday loans has been referred to as the “debt spiral” because it traps the borrowers into a pattern of refinancing an extremely expensive cash loan past the initial payback period. For the lenders, it is advantageous and profitable to have as many loan transactions as possible.
There have been legislative efforts by some jurisdictions to limit or restrict the practice of rolling over payday loans. However, handshake agreements between lenders and desperate borrowers have found other ways to perpetuate the “debt spiral.” Referring to an example shown in FIG. 2, a borrower makes a first loan request of $300 and is granted the first loan from a first lender, minus a $75 loan fee. When the first loan becomes due and payable on the next payday, the borrower may already know or may simply be referred to a second lender. The borrower executes a second loan in the amount of $400 and is granted the second loan from the second lender, minus the $100 loan fee of course. Thus, the borrower takes the $300 net cash, returns to the first lender and pays off the first loan with the first lender. On the next payday, the borrower finds themselves unable to payoff the second loan, so the borrower goes through the process again with either the first lender or with a third lender and the cycle continues for as long as the borrower can qualify for the increased loan amounts. In just the three identified transactions, the cumulative fees totaled to $300 and the borrower's payoff balance has nearly doubled from $300 to $525.
The payday lending industry operates in both brick and mortar infrastructure and through online portals. Some lenders operate exclusively online believing that the operating and transaction costs for servicing payday type loans is lower because there are no leased buildings, fewer employees, and no concerns about securing and handling physical stores of cash. In addition, the online lender is not limited to relying on local customers because the online lender has the ability to reach a vast pool of potential customers—anyone with access to the internet, for example. Theoretically, the online lender could reach a large pool of customers and then amortize the associated transaction costs into lower fees for the borrowers.
FIG. 3 shows an example of the relative operating costs for a brick and mortar lender 10 compared to an online lender 12. The infrastructure and labor costs 14 are estimated to be, on average, significantly higher for the brick and mortar lender 10 than they are for the online lender 12. As briefly mentioned above, the brick and mortar lender 10 has capital costs, equipment costs, lease or building acquisition costs, labor costs, security costs, money handling costs, etc.
Write off costs 16, which are the costs that must be absorbed when the borrower defaults on the loan, are estimated to be about the same for the brick and mortar lender 10 and the online lender 12. Conventionally and quite commonly, the lender 10, 12 mitigates the risk of default or insufficient funds by requiring the borrower to identify their next payday and executing an agreement for an electronic funds transfer (EFT) from the borrower's bank or credit union account on that day. In some cases, the borrower, either purposefully or mistakenly, may provide a payday date that is incorrect. In such a situation, the borrower withdraws their money well before the EFT instructions are received by the bank or credit union. In other cases, the borrower simply does not have enough funds to payoff the loan and must default on at least a portion of the loan amount. In either scenario, the lenders 10, 12 must bear the costs of dealing with the defaulting borrower.
As for marketing and advertising costs 18, it is estimated that the brick and mortar lender 10 has significant advantages over the online lender 12. The brick and mortar lender 10 typically attracts new borrowers by simply being present and visible to the local citizens. By being located in a preferred location, the brick and mortar lender 10 may be able to generate and sustain a profitable business from the local population with little to no advertising costs. The online lender 12, on the other hand, has significant costs of attracting and ultimately acquiring new borrowers. Given the hundreds of competitors, the similarity of services, and the commodity nature of the money lending business, the online lender 12 must advertise heavily to differentiate from others and may also have to commit significant resources on search engine optimization to rise to the top of an internet search. In sum, the online lender 12 trades the infrastructure and labor costs 14 for an equal or more expensive challenge of attracting and acquiring new borrowers online.
There have been attempts to reduce the cost of acquiring new customers. For example, U.S. Published Patent Application No. 2005/0075969 to Neilson et al. (Neilson) discloses a payday loan process having independent, but related contracts. The lending entity enters into a first contract with an employer and a second contract with an employee. The first contract provides that if an employee takes out an advance with the lending entity, then the employer is obligated to deduct the advance amount and related fees from the next paycheck of the employee and send this on to the lending entity. The second contract is executed separately with the employee. The second contract obligates the employee to authorize the employer to deduct the loan payoff amount and any fees from the employee's next paycheck. One drawback of Neilson is that the payday loan process taught therein continues the practice of requiring full restitution of the payday loan on the next payday while extracting high loan fees from the borrower.
Many practices and aspects of the payday lending industry have presented challenging issues for governments and consumer advocates. There continues to be a strong desire and even a strong need for small, short term cash infusions for people, especially people in the lower income sections of society. In addition and as mentioned above, mainstream financial institutions are unable to profitably service small, short term payday loans, so the people needing these types of loans must suffice with the existing model. However, the excessive fees and interest associated with the payday loans, the unforeseen “debt spiral,” and the practice of rolling over loans multiple times has severely damaged the reputation and efficacy of the payday lending industry.
In response to the practices and tactics of the payday lending industry with respect to military personal, the U.S. government recently enacted legislation and regulations capping the interest rate to 36.00 percent on small consumer cash loans. Thus, the loan fees associated with payday loans cannot be greater than an amortized APR of 36.00%. See Public Law 109-364, John Warner National Defense Authorization Act for Fiscal Year 2007. The term “interest” is defined to include all extra charges and fees of any kind, including the sale of related products such as credit insurance.
The new law prohibits requiring military members to set up an allotment as a condition of receiving a loan; requiring the use of a vehicle title as security for any loans made to service members and military family members; using a check or any other access to a member's financial account as security for a loan; lenders from renewing, repaying, refinancing, rolling over, or consolidating consumer credit using the proceeds of other credit granted by the same lender to the military member; requiring military members to waive their rights under the Servicemembers' Civil Relief Act (SCRA), or any other federal law; denying the opportunity for military members to pay the loan off early, and any penalties for early payments; any unreasonable clauses in the contract designed to make it difficult for military members to take a creditor to court; and states from allowing creditors to violate state consumer loan protection laws for military members who are nonresidents. In short, the new law effectively closes down payday lending operations around military bases and to military personnel.
Closing down the payday lending operations around the military bases, however, may not cure the problem. Similar to the borrower involved in a cycle of obtaining loans from a variety of lenders, it is anticipated that military personnel will still continue to find ways of obtaining short term payday loans. Since the payday loan shops around the bases can no longer provide the loans, it is anticipated that many military personnel will use online payday loan vendors. Some of the high-fee, online lenders may be out of reach of government laws, while others may claim that they were not aware the borrower was a member of the military. Thus, while closing down the payday loan shops around the bases may have some positive effects, it does not cure the underlying issues and problems. Instead, closing down the payday loan shops around the bases is likely to simply shift the business to another venue, such as to online vendors, where oversight and enforcement of regulations may be much more difficult.
Commercial banks, with multiple physical locations and online resources, have been unable to profitably transact and process short term loans. This is due, in part, because of the federal banking deregulation of 1980, which caused for-profit banks to become increasingly cost conscious and bottom-line minded. The customer segment that needed small, unsecured cash loans to meet occasional emergencies, posed several problems in the banking industry's business model. First, the effort to originate and underwrite a loan is relatively costly and banks must meet certain professional, safety, and soundness standards. To recoup the transaction costs and still make a profit, commercial banks found that they would typically have to exceed the state usury laws governing their charter. Because the emergency loan amount required was small and the repayment term short, the resulting APR rate triggered usury violations. Instead of trying to find an alternate model, for-profit banks have essentially abandoned the servicing of small, unsecured cash loans to and have shifted their focus to a lower-risk target customer borrowing larger amounts over a longer period.
The payday lending industry operates under a business model, anticipated profit margin, and an overall business philosophy that prevents them from remodeling or even correcting some of the most glaring drawbacks within the industry. Although it is appreciated that small, short term cash loans may be a necessary survival tactic for some people, there is an urgent and overriding need for fundamental changes in the industry. In addition, there remains a need to provide military personnel small, short term cash loans within the boundaries of the new law, while keeping operating and transactions costs to a minimum.